MID-TERM Examination # 1 (30%)

No credit without supporting calculations in Microsoft Excel and final results should be
demonstrated in Word. Both Excel and Word must be submitted concurrently. Round up to two
digits after the point.

1.If an FI funds $60 million one-year assets paying 12% interest per annum with $60 million
three – year liabilities paying 6% interest per annum.
a) What will be the bank’s net interest income at years 1 and 2, if at the end of the first year all
interest rates have decreased by 0.7 percent (70 basis points)?
Year 1 = 3.6 mln Year 2 = -3.18 mln
b) What type of interest rate risk is this: refinancing or reinvestment?
Reinvestment

2 A bank invested $50 million in a two-year asset paying 10 percent interest per annum and
simultaneously issued a $50 million, one-year liability paying 8 percent interest per annum.
a) What will be the bank’s net interest income each year if at the end of the first year all interest
rates have increased by 1 percent (100 basis points)?
NII Year 1 = 1 mln, Year 2=500k

b) What type of interest rate risk is this: refinancing or reinvestment?

3. Corporate bonds usually pay interest semiannually. If a company decided to change from
semiannual to annual interest payments, how would this affect the bond’s interest rate risk?

4. Two ten-year bonds are being considered for an investment:

The first bond is a ten-year premium bond with a coupon rate higher than its required rate of
return.
The second bond is a zero-coupon bond that pays only a lump-sum payment after ten years with
no interest over its life. Which bond would have more interest rate risk (that is, which bond’s
price would change by a larger amount for a given change in interest rates) if:
a) Investor plans to liquidate bonds before the maturity of bonds.
b) Both bonds are kept till maturity.
Explain your answers.

5. Assume that a US bank has assets located in Germany worth Euro 150 million on which it
earns an average of 8 percent per year. The bank has Euro 100 million in liabilities on which it
pays an average of 6 percent per year. The current spot rate is 1.5$/Euro.
a. What type of exchange rate movement concerns this bank?
b. If the exchange rate at the end of the year is 1.2$/ Euro, what is the effect in dollars on the net
interest income from the foreign assets and liabilities?

Measurement in £
Interest received = £12 million
Interest paid = £6 million

Net interest income = £6 million

Measurement in $ before £ devaluation

Interest received in dollars = $8 million

Interest paid in dollars = $4 million

 Net interest income = $4 million

Measurement in $ after £ devaluation

Interest received in dollars = $10 million

Interest paid in dollars = $5 million

Net interest income = $5 million

The dollar will have appreciated, or conversely, the £ will have depreciated

6. An investment banker agrees to underwrite a $400,000,000, 7-year, 9 percent semiannual

bond issue for a corporation on a firm commitment basis. The investment banker pays a
corporation on Thursday and plans to begin a public sale on Friday. What type of interest rate
movement does the investment bank fear while holding these securities? If interest rates rise by 8
basis points, overnight, what will be the impact on the profits of the investment banker? What if
the market interest rate falls by 8 basis points?

An increase in interest rates will cause the value of the bonds to fall. If rates increase 8 basis
points over night, the bonds will lose in value. The investment bank will absorb the decrease in
market value, since the issuing firm has already received its payment for the bonds. If market
rates decrease by 8 basis points, the investment bank will benefit by the increase in market
value of the bonds

7. Suppose, there is a 10-year, AAA-rated Swiss bond traded at par that is paying an annual
coupon of 6%. The bond has a face value of 10,000 Swiss francs (SF) and traded at 6% yield.
The spot rate at the time of purchase is SF1.55/$. At the end of the year, the bond is downgraded
to AA and the yield increases to 8 percent. In addition, the SF appreciates to SF1.4/$.
a. What is the net return on investments (%) for a Swiss investor who holds this bond for a year?
What portion of this loss or gain is due to foreign exchange risk? What portion is due to interest
rate risk?
b. What is the net return on investments (%) if a U.S. investor who holds this bond for a year?
What
portion of this loss or gain is due to foreign exchange risk? What portion is due to interest rate
risk?

9. A financial institution has the following balance sheet structure:

Assets
Cash $1,000
Bond, 10 years, 10% fixed
Coupon $10,000
Loans, 5 years, 15% fixed $30,000
coupon, reset every year $15,000
Fixed assets $9,000
Total assets $50,000
Liabilities and Equity
Demand deposits $10,000
Time deposits, 1 year, 6% $20,000
Bonds, 15 years, 11% floating
Equity $ 5,000
Total Liabilities and Equity $50,000

The FI expects no additional asset growth.

a. What will be the net interest income (NII) at the end of the first year?
Current expected interest income: 50 000(0.10) + 30 000(0.15) = 9500.
Expected interest expense: 20000(0.06) +5000(0.11) = 1750
Expected net interest income: = 7 750.
b. If at the end of year 1, market interest rates have increased 100 basis points, what will be
the net interest income. If a bank manager is certain that interest rates were going to increase
within the next six months, how should the bank manager adjust the bank’s maturity gap to take
advantage of this anticipated increase?
Current expected interest income: 50 000(0.11) + 30 000(0.16) = 10300.
Expected interest expense: 20000(0.07) +5000(0.12) = 2000
Expected net interest income: = 8300.

10. The spot exchange rates are currently as follows (all given in base/quote format): USD/CHF
0.980, GPD/USD $1.56, and USD/JPY ¥125.0
If the Japanese yen appreciates by 2.0%, what is the bank's expected gain or loss (note: this is
variation on Saunders’ Question #8) in US dollar terms? Refer to the following table.

Bank expected to gain in case of appreciation of yen by 2%

11. County Bank has the following market value balance sheet (in millions, annual rates):
Assets
Cash $20
15-year commercial loan @ 10%
interest, annually $160
30-year Mortgages @ 8%
monthly amortizing $300 annually
Total Assets $480
Liabilities and Equity
Demand deposits $100
5-year CDs @ 6% interest,
balloon payment $210
interest, 20-year debentures
@ 7% interest $ 120
Equity $50
Total Liabilities & Equity $480

a. What is the maturity gap for County Bank?

MA = [0x$20 + 15x$160 + 30x$300]/$480 = 23.75 years.
ML = [0x$100 + 5x$210 + 20x$120]/$430 = 8.02 years.
MGAP= 23.75-8.02 = 15.73 years
b. What will be the maturity gap if the interest rates on all assets and liabilities increase by 1 %?
Cash = 20
Comm loan = 16*PVIFA+160PVIF=148.49
Mortgages = 24*PVIFA+300PVIF=269.18
M=(0*20+148.49*15+269.18*30)/(20+148.49+268.18) = 23.54

c. What will happen to the market value of the equity?

12. FI International holds seven-year International bonds and two-year Beta Corporation bonds.
The International bonds are yielding 12 percent and the Beta bonds are yielding 14 percent under
current market conditions.
a. What is the weighted-average maturity of FI’s bond portfolio if 40 percent is in International
bonds and 60 percent is in Beta bonds?
b. What proportion of International and Beta bonds should be held to have a weighted-average
yield of 12.5 percent?
c. What will be the weighted-average maturity of the bond portfolio if the weighted-average
yield is realized?
13. Gunnison Insurance has reported the following balance sheet (in thousands):
Assets Liabilities and Equity
2-year Treasury note $175 1-year commercial paper $135
15-year municipal bonds $165 5-year note $160
Equity $45
Total Assets $340 Total Liabilities & Equity $340
All securities are selling at par equal to book value. The two-year notes are yielding 5 percent,
and the 15-year municipal bonds are yielding 9 percent. The one-year commercial paper pays 4.5
percent, and the five-year notes pay 8 percent. For simplicity, all instruments pay interest
annually.
a. What is the weighted-average maturity of the assets for Gunnison?
b. What is the weighted-average maturity of the liabilities for Gunnison?
c. What is the maturity gap for Gunnison?
d. What does your answer to part (c) imply about the interest rate exposure of Gunnison
Insurance?
e. Calculate the values of all four securities of Gunnison Insurance’s balance sheet assuming that
all interest rates increase 2 percent. What is the dollar change in the total asset and total liability?
values? What is the percentage change in these values?
f. What is the dollar impact on the market value of equity for Gunnison?
14. Consider a $1,000 bond that pays a semiannual coupon of 10 percent and trades at a
yield of 14 percent. The maturity of the bond is 25.08.2018. Use the current date as the
settlement day.
a) Calculate the duration of this bond.
b) What is the expected change in the price of the bond predicted with duration if interest rates
decline by 50 basis points immediately after you purchase a bond? Calculate the new bond price
implied by duration.
c) What is the actual bond price if interest rates decline by 50 basis points immediately after your
purchase a bond? Calculate the error amount of duration model prediction.
15. Problem: You purchase a five-year, 13.76 % bond that is priced to yield 10 %. Your
investment horizon is 4 years and the target amount is 1672$.
a) Show that the duration of this annual payment bond is equal to 4 years.
b) Show that, if interest rates rise to 11 % within the next year and that if your investment
horizon is four years from today, you will still the target amount.
c) Show that the same amount also will be earned if interest rates fall next year to 9 %.
16. A financial institution has an investment horizon of 2 years, 9.5 months. The institution
has converted all assets into a portfolio of 8 percent, $1,000, 3-year bonds that are trading
at a YTM of 10 percent. The bonds pay interest annually. The portfolio manager believes
that the assets are immunized against interest rate changes.
a. Is the portfolio immunized at the time of bond purchase? What is the duration of the bonds?
b. Will the portfolio be immunized one year later?
c. Assume that one-year, 8 percent zero-coupon bonds are available in one year. What proportion
of
the original portfolio should be placed in zeros to rebalance the portfolio?

17. M- Bank has an asset portfolio that consists of $100 million of 30-year, 8 percent
coupon, $1,000 bonds that sell at par.
a. What will be the new prices if market yields change immediately by 2.00 percent?
b. The duration of these bonds is 14.1608 years. What are the predicted bond prices in each of
the
four cases using the duration rule? What is the amount of error between the duration prediction
and the actual market values?
c. Calculate the convexity of these bonds using the shortcut formula and the 200 basis points
yield
change
d. Given that convexity, what are the bond price predictions in each of the four cases using the
duration plus convexity relationship? What is the amount of error in these predictions?

18. City Bank issued $200.0 million of one-year CDs in the United States at a rate of 3.50%.
It invested part of this money, $100.0 million, in the purchase of a one-year bond issued by a
U.S. firm at an annual rate of 4.0%. The remaining $100.0 million was invested in a one-year
Brazilian government bond paying an annual interest rate of 5.0%. The exchange rate at the
time of the transaction was USDBRL R$ 3.5000. If the Brazilian real appreciates (against the
dollar) from R$ 3.5000 to R$ 3.0000, what is the net return on this $200.0 million investment?
19. Nearby Bank has the following balance sheet (in millions):

Assets Liabilities and Equity

Cash $60 Demand deposits $140
5-year treasury notes $60 1-year Certificates of Deposit $160
30-year mortgages $200 Equity $20
Total Assets $320 Total Liabilities and Equity $320

What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to an increase
or decrease in interest rates? Explain why?

20. Consider the following balance sheet (in millions) for an FI:

Assets Liabilities
Duration = 10 years $950 Duration = 2 years $880
Equity $70

a. What is the FI's duration gap?

b. What is the FI's interest rate risk exposure?

c. How can the FI use futures and forward contracts to put on a macrohedge?

d. What is the impact on the FI's equity value if the relative change in interest rates is an
increase of 1 percent? That is, R/(1+R) = 0.01.
 e. Suppose that the FI in part (c) macrohedges using Treasury bond futures that are
currently priced at 96. What is the impact on the FI's futures position if the relative
change in all interest rates is an increase of 1 percent? That is, R/(1+R) = 0.01.
Assume that the deliverable Treasury bond has a duration of nine years.

f. If the FI wanted a perfect macrohedge, how many Treasury bond futures contracts does
it need?

21. Two bonds are available for purchase in the financial markets. The first bond is a 2-year,
$1,000 bond that pays an annual coupon of 10 percent. The second bond is a 2-year, $1,000,
zero-coupon bond.

a. What is the duration of the coupon bond if the current yield-to-maturity (YTM) is 8
percent? 10 percent? 12 percent? (Hint: You may wish to create a spreadsheet
program to assist in the calculations.)

22. What is the duration of a five-year, $1,000 Treasury bond with a 10 percent semiannual
coupon selling at par? Selling with a YTM of 12 percent? 14 percent? What can you
conclude about the relationship between duration and yield to maturity? Plot the
relationship. Why does this relationship exist?

23. What is the duration of a consol bond that sells at a YTM of 8 percent? 10 percent? 12
percent? What is a consol bond? Would a consol trading at a YTM of 10 percent have a greater
duration than a 20-year zero-coupon bond trading at the same YTM? Why?

24. A six-year, $10,000 CD pays 6 percent interest annually. What is the duration of the CD?
What would be the duration if interest were paid semiannually? What is the relationship of
duration to the relative frequency of interest payments?
25. The balance sheet for Gotbucks Bank, Inc. (GBI) is presented below ($ millions):

Assets Liabilities and Equity

Cash $30 Core deposits $20
Federal funds 20 Federal funds 50
Loans (floating) 105 Euro CDs 130
Loans (fixed) 65 Equity 20
Total assets $220 Total liabilities & equity $220

NOTES TO THE BALANCE SHEET: The Fed funds rate is 8.5 percent, the floating loan rate is
LIBOR + 4 percent, and currently LIBOR is 11 percent. Fixed rate loans have five-year
maturities, are priced at par, and pay 12 percent annual interest. Core deposits are fixed-rate for
2 years at 8 percent paid annually. Euros currently yield 9 percent.

a. What is the duration of the fixed-rate loan portfolio of Gotbucks Bank?

b. If the duration of the floating-rate loans and fed funds is 0.36 years, what is the duration
of GBI’s assets?
c. What is the duration of the core deposits if they are priced at par?

d. If the duration of the Euro CDs and Fed funds liabilities is 0.401 years, what is the
duration of GBI’s liabilities?

e. What is GBI’s duration gap? What is its interest rate risk exposure?

f. What is the impact on the market value of equity if the relative change in all market
interest rates is an increase of 1 percent (100 basis points)? Note, the relative change in
interest rates is (R/(1+R)) = 0.01.

g. What is the impact on the market value of equity if the relative change in all market
interest rates is a decrease of 0.5 percent (-50 basis points)?